June 4, 2010

Trust Administration - Taxes, Uniform Prudent Investor Act & Accounting

It is not uncommon for a trust to endure for many years after the original drafter(s), the settlor(s), have passed away. This can be classified as long-term trust administration. 

For example, husband and wife draft a trust with the survivor inheriting everything. Then upon the surviving spouse’s death, the remainder of the trust estate distributes to the children in equal shares outright and free of trust, provided the children are at least 25 years old. Even though at first glance it does not appear that long-term trust administration is likely, there is the distinct possibility that it may arise. For the sake of argument, let us assume that husband and wife pass away in an auto accident, leaving Son, age 18 and Daughter, age 20. Son’s trust would require 7 years of administration while Daughter’s trust would require 5 years of administration. The following are common hurdles that would be encountered in the long-term trust administration of Son and Daughter’s trust.

1. Tax Returns

First, the trustee should file Form 56 with the IRS to notify it that a fiduciary relationship exists between the trustee and the trust. IRC §§6903, 7701(a)(6); Treas Reg §301.6903-1. Second, the trustee would need to acquire a federal identification number for the trust in order to properly file tax returns. Third, the trustee would need to annually file federal and state tax returns depending on the trust’s circumstances. In particular, a trust must file a tax return in California if either the net taxable income is over $100 or the gross income exceeds $10,000, regardless of the net taxable income. Rev & T C §18505(e)-(f); FTB Form 541. A federal return must be filed if the trust has any taxable income or gross income of $600 or more, regardless of the amount of taxable income. IRC §6012(a)(4); IRS Form 1041.

2. Investments of Trust Assets - Uniform Prudent Investor Act (UPIA)

The trustee needs to be mindful of the Uniform Prudent Investor Act (UPIA) which governs investment and management of trust assets. Probate Code §§16045-16054. The UPIA is the default rule as the trust can specify a different method in evaluating a trustee’s investment decisions. Prob C §16046(b). However, most trusts do not expand or restrict the UPIA standards. Here are some important sections from the UPIA.

First and foremost, the duty of care requires that “a trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution. Prob C §16047(a). Although, “a trustee's investment and management decisions respecting individual assets and courses of action must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust." Prob C §16047(b). Therefore, the fact that the trustee made 10 good and 1 bad investment choices that resulted in a positive outcome for the trust does not violate UPIA.

Furthermore, “the trustee has a duty to diversify the investments of the trust unless, under the circumstances, it is prudent not to do so.” Prob C §16048. Hence, the trustee could probably not invest all trust assets in volatile stocks like British Petroleum or Goldman Sachs.

Additionally, a trustee may delegate investment and management functions, if prudent under the circumstances, to an agent of the trustee. Prob C §16052(a). Thus, a trustee could appoint a certified financial planner to assist the trustee in making investment decisions.

Moreover, “the trustee must, within a reasonable time of accepting the trusteeship or receiving the assets, review the assets and make and implement decisions concerning the retention and disposition of assets so as to bring the trust portfolio into compliance with the purposes, terms, distribution requirements, and other circumstances of the trust.” Consequently, the trustee would need to perform an inventory of the trust and determine the future goals and needs of the trust in order to achieve the trust’s stated goals.

3. Accounting

The trustee is generally required to provide at least an annual accounting to beneficiaries for trusts created on or after June 30, 1987. See Prob C §16062. An accounting is also required when there is a change of trustee and when the trust terminates. Prob C §16062(a). The accounting must contain the information specified in Prob C §16063, which is too long to cite here (trust me). However, a beneficiary may waive in writing the right to an accounting from the trustee. See Prob C §16064(c).